Now that HMRC’s cost-sharing exemption consultation has closed, Graham Elliott offers his expert view of the likely outcome.
By the time you are reading this, the deadline for commenting on HMRC’s ‘Draft Guidance’ in respect of the proposed new cost-sharing exemption will have closed. What comes out of this consultation is anyone’s guess (at the time of writing). Some of what I comment on below may have changed, but most of the changes are likely to be in the area of clarity of expression rather than changes in the operation of the rules.
The new legislation becomes effective on the date of Royal Assent to the 2012 Finance Bill. In theory it has always had “direct effect” by virtue of being a mandatory provision under the Principal VAT Directive, and HMRC has acknowledged that point without going into any further detail. In practice, anyone wishing to seek to re-characterise earlier supplies as ones falling under the cost-sharing exemption will be expected, by HMRC at least, to have complied with all of the current proposals, when carrying out that activity in the past. It is an interesting point as to whether, without any specific UK legislation having applied in the past, HMRC can restrict its application only to the current proposed rules. As we shall see, the current proposed rules are extremely restrictive and potentially very complicated.
First, however, to remind people as to what the provision will deliver: Currently, where any organisation provides services to a counter-party, where they are not group-registered, VAT is chargeable on those services unless they fall into a specific exemption (such as certain supplies for education, for instance). In particular, this has tended to blight the sharing of back-office services involving a large element of employee cost. It is not possible, under normal rules, even to share costs on a pure reimbursement model, except where certain very limited concessions are applied by HMRC.
Basis of new rules
The new exemption promises to allow for “VAT-free” sharing of services as long as certain very detailed conditions are met. It is interesting to note that the new VAT legislation - group 16, schedule 9 VATA 1994 - will express those rules in very general terms, effectively transposing, with some minor grammatical changes, the brief legislation already present in the Principal VAT Directive. However, the detailed implementation of those rules will be set out in ‘guidance’ issued by HMRC. HMRC appears to be keen to leave it to the guidance to set out the rules, rather than providing further more detailed legislation. However, it would probably introduce tertiary legislation, namely regulations, if the guidance were challenged.
One potential reason for this, though unspoken, is that HMRC has concerns over the EC Commission introducing infraction proceedings for failure to implement the exemption properly. That may be easier for them to do if they have specific legislation to aim at, rather than a set of guidance notes which are arguably not binding on the taxpayer.
From this point on, I refer to the guidance as though they set out immutable rules even though it is doubtful as to whether guidance can ever do that.
Need for a new body
The first rule is that there must be a formal recognised membership comprising independent bodies, which is to say, organisations which are at arms’ length from each other and are not related parties. There must be at least two such organisations, but there is no theoretical maximum.
Whilst these organisations are not able simply to share resources across the “group”, they must instead form a completely new entity which will then provide the qualifying exempt services. Where all of the conditions are met, the provision of those services from the new entity to each member of the group will be exempt from VAT, rather than taxable as would be the case outside of the group arrangement.
The nature of the entity to be set up (which I will now refer to as Cost-Sharing Co) is not specified, and in theory can be any kind of entity. The most likely, in practice, will be a company limited by shares. However, whatever structure is chosen, each of the members of the group must have an ownership involvement with Cost-Sharing Co, and no-one who is not a member of the group can have such an ownership involvement. Ownership does not have to be equal, and one member of the cost-sharing group can own a controlling majority of the shares of Cost-Sharing Co. In practice, that is helpful, because it will make it possible for Cost-Sharing Co to form a VAT group with one of the members. The consequences of this will be discussed further below.
As to who can qualify to be a member of the group, and what the qualifications are for supplies by Cost-Sharing Co to those members to actually be exempt, this is where the practical difficulties can arise (even having got past the obvious hurdle of having to set up the separate entity).
It needs to be remembered that the purpose of the provision in the VAT Directive is to allow organisations which do not carry out taxable activities to share costs in a way that does not create a VAT liability. Therefore, all of the services provided by Cost-Sharing Co need to be used by each member ‘solely’ for non-taxable activities, subject to certain qualifications. However, since it would be too restrictive to exclude from membership of the group any entity which had any taxable supplies, there is a relaxation which can be applied to help qualify for membership. This is based on the ratio of non-taxable to taxable activities of each potential member. That test, which is strictly to do with membership of the group (not whether the supplies themselves are exempt), is that no less than 5 per cent of the activity of the potential member must be non-taxable. That obviously leaves up to 95 per cent which could be taxable.
“Directly necessary” test
However, that is far from the only consideration when the consumption of the relevant services is in point. In order for the services on each occasion to be exempt from VAT when purchased by a member of the cost-sharing group, the actual use of the services in question has to relate to the non-taxable activities, and this is referred to as being “directly necessary” for carrying out those activities. As a simplification de minimis principle, it is accepted that a direct link with non-taxable activities arises where the use of the services from Cost-Sharing Co is at least 85 per cent non-taxable. This immediately creates quite a distinction between the entry level for membership of the cost sharing group as such, and the ability to source exempt services once one has become a member.
The guidance includes comments as to how to ensure that the 85 per cent test is being met, and any manager involved in running Cost-Sharing Co will be extremely interested in setting up procedures for ensuring that these qualifications do not present difficulties.
That manager will need to be aware that “non-taxable activities” do not include zero-rated activities, nor activities which are simply carried on outside the UK (since these are generically taxable). Nor is it fair to say that an organisation which is not registered for VAT is carrying out only non-taxable activities, because the activities might be taxable per se even if the VAT registration thresholds themselves are not breached. The scope for mis-understanding of this point is considerable. Non-taxable activities are basically exempt activities and non-business activities.
Cost reimbursement test
But that is not all. In order for the exemption to apply the charges made by Cost-Sharing Co also cannot exceed a mere reimbursement of the cost that it incurs. In this respect HMRC is very wary about the possibility of Cost-Sharing Co paying third party charges which create profit extraction, thus giving rise to an appearance that Cost-Sharing Co only recoups costs, even though it is actually funnelling profits to another party. Its concern is understandable because that would give rise to something close to a commercial outsourcing arrangement. For the most part this will be irrelevant to charities, since charities would not be entering into arrangements with a view to achieving joint outsourcing, but rather for genuine cost-sharing purposes. Nonetheless, HMRC officers will be wary about covert profit extraction, and charities can expect to be caught up in this pre-occupation.
Since Cost-Sharing Co will have to manage its finances with a keen eye on working capital and investment for the future, HMRC recognises that a mere reimbursement of costs can nonetheless involve a level of charge which builds up financial resources for future investment, and in particular saving up for capital investment. What is needed, however, is a very clear financial plan that shows that that is all that is being achieved, and that surpluses will not build up indefinitely. We are also told that there needs to be an “audit trail” which will assist in demonstrating this.
Distortion of competition test
Even that is not all. For the exemption to apply the group needs to be able to show that Cost-Sharing Co is not in competition with commercial providers such as will distort competition. By and large this seems almost unimaginable in a situation where there is mere cost reimbursement, since no commercial operator would be able to compete with that kind of model, as it would need to generate a profit. The draft guidance generally recognises this in a sensible and balanced way. There is, though, an unwelcome comment to the effect that the way in which the existence of Cost-Sharing Co, and its possible services to new members, might be advertised or broadcast could make an impact on whether it meets the distortion of competition criterion. It seems to suggest that the only way that Cost-Sharing Co’s existence can be communicated is by word of mouth or personal recommendation. This is extraordinarily restrictive given that the entire basis of mere cost reimbursement makes it virtually impossible for a Cost-Sharing Co to compete with genuine commercial providers. I hope that this will be ‘toned down’ in the revised guidance.
With all of these criteria in place, Cost-Sharing Co can then make exempt supplies to its members. It can make taxable supplies which fall outside the strict exemption criteria mentioned above to members as well. It can also make taxable supplies to non-members.
The most obvious impact this will have is that, the supplies being exempt, there will be no VAT for the exempt or non-business purchaser to suffer in the supply chain. But that is only true if the resources can be acquired by Cost-Sharing Co on a non-VAT charged basis. Here is where the fact that a separate entity has to be set up can cause difficulties.
If the separate entity is of enough substance to employ its own staff, who provide the services, and rent own premises, pay rates, and so on, then that objective can be achieved. But many organisations will realise that this is easier said than done, and that what they really want is to be able to share their own staff across a group of organisations, rather than having to arrange for a new organisation to take on all of those resources, with all of the attendant difficulties. A small but important movement towards creating that level of utility arises in the fact that any Cost-Sharing Co which is controlled by one of the members can group register with that member (subject to the usual rules). If, therefore, all of the available resources for sharing are held within that particular member, they can be sold on a VAT-free basis to Cost-Sharing Co within the VAT group, and this means that no VAT will have arisen on the movement of those resources into the Cost-Sharing Co. That VAT group will make increased exempt supplies, which means that there will be a small cost in terms of irrecoverable VAT on its own overheads, and this needs to be factored into the financial planning. But the spectre of VAT arising on a supply of staff into the Cost-Sharing Co, which would have made a mockery of the whole point of the exemption, can thus be removed.
What is not possible is for any of the other members of the cost sharing arrangement to sell the services to Cost-Sharing Co on an exempt basis; so, once again, all of the resources do need to be concentrated in one particular part of the group in order for this to work.
With those restrictions in mind, it will be interesting to find out how many groups of charities will really find this practical. It would immediately appeal in a situation where a large, well endowed, charity provides the services to other smaller charities on the basis of group-registering with Cost-Sharing Co, allowing the resources to flow from the large charity, via Cost-Sharing Co, to the other sharing charities without VAT.
There is of course the possibility of more equal-sized organisations coming together, but then they would have to cede to one of the members a majority shareholding in Cost-Sharing Co and then give some strong commercial guarantees to that charity in consideration of the employment costs the charity will take on, which the other members will be prepared to pay. It could become difficult for them to stick to any such pre-ordained formula if they could not use enough services, since charities ought not to pay more for services than their real worth. This therefore could end up being impracticable.
The other alternative, which is for the Cost-Sharing Co to set up without a VAT group, and employ its resources direct, runs the risk that people will not wish to become employees of an organisation which appears to have no particular history or basis for existence. Landlords may experience a similar reluctance to provide premises.
For these reasons, this is not an easy fix to the difficulty of VAT being created by intercompany charging. The very complexities to which the basically unsatisfactory European law enshrining this exemption gives rise may have been the reason for the exemption not having been adopted into UK legislation many years ago, as it ought to have been. Only time will tell whether this is an exemption which becomes a white elephant, whose main or sole existence is merely as an entry in a book of tax legislation.
Graham Elliott is a partner and VAT expert at haysmactintyre